Explainer: How does negative rate policy work?

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(Reuters) - U.S. President Donald Trump has suggested that the U.S. Federal Reserve drive interest rates into negative territory. He says his motivation was to refinance the U.S. government’s $22 trillion in outstanding debt and lengthen the amount of time over which it is repaid. [nL2N26208B]

Negative rate policy is something Fed officials have downplayed as appropriate in the U.S. because of the risks it entails and the likely political opposition.

Once considered only for economies with chronically low inflation such as Europe and Japan, however, the idea is becoming a more attractive option for some other central banks to counter unwelcome rises in their currencies.

This is how a negative rate policy works and its potential pitfalls:

WHY HAVE SOME CENTRAL BANKS ADOPTED NEGATIVE RATES?

To battle the global financial crisis triggered by the collapse of Lehman Brothers in 2008, many central banks cut interest rates near zero. A decade later, interest rates remain low in most countries due to subdued economic growth.

With little room to cut rates further, some major central banks have resorted to unconventional policy measures, including a negative rate policy. The euro area, Switzerland, Denmark, Sweden and Japan have allowed rates to fall slightly below zero.

HOW DOES IT WORK?

Under a negative rate policy, financial institutions are required to pay interest for parking excess reserves with the central bank. That way, central banks penalize financial institutions for holding on to cash in hope of prompting them to boost lending.

The European Central Bank (ECB) introduced negative rates in June 2014, lowering its deposit rate to -0.1% to stimulate the economy. Given rising economic risks, markets expect the ECB to cut the deposit rate, now at -0.4%, in September.

The Bank of Japan (BOJ) adopted negative rates in January 2016, mostly to fend off an unwelcome yen spike from hurting an export-reliant economy. It charges 0.1% interest on a portion of excess reserves financial institutions park with the BOJ.

WHAT ARE THE PROS, CONS?

Aside from lowering borrowing costs, advocates of negative rates say they help weaken a country’s currency rate by making it a less attractive investment than that of other currencies. A weaker currency gives a country’s export a competitive advantage and boosts inflation by pushing up import costs.

But negative rates put downward pressure on the entire yield curve and narrow the margin that financial institutions earn from lending. If prolonged ultra-low rates hurt the health of financial institutions too much, they could hold off on lending and damage the economy.

There are also limits to how deep central banks can push rates into negative territory - depositors can avoid being charged negative rates on their bank deposits by choosing to hold physical cash instead.

WHAT ARE CENTRAL BANKS DOING TO MITIGATE THE SIDE-EFFECTS?

The BOJ adopts a tiered system under which it charges 0.1% interest only to a small portion of excess reserves financial institutions deposit with the central bank. It applies a zero or +0.1% interest rate to the rest of the reserves.

The ECB is also expected to take “mitigating measures,” such as a partial exemption from the charge in the form of tiered deposits rates, if it were to deepen negative rates from the current -0.4%, analysts say.

But designing such a scheme won’t be easy in a bloc where cash is distributed unevenly among countries. It could even backfire by pushing rates up in certain countries, rather than down.

Reporting by Leika Kihara in Tokyo and Balazs Koranyi in Frankfurt; Editing by Alex Richardson and Nick Zieminski